Why Investors Are Dumping Stock Funds for ETFs

Those billions flying out of mutual funds this year are finding a home in exchange-traded funds, where they're riding a rally and fueling a trend that market pros say is here to stay.

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ETFs have gathered $8.3 billion in new funds so far in 2012, while their actively managed cousins have seen nearly identical outflows of $7.9 billion.

Though one of the main investing themesthis year is a clear rotation away from the things that worked in 2011 and towards the things that didn't work, the trend toward index funds has continued unabated, propelled especially by the market's mostly straight-line path higher.

"This is really about the clients being aware of cost efficiencies," says Julie Casserly, president of JMC Wealth Management in Chicago. "They average investor is not going to like ETFs when the markets tank, and they're going to think they're the best thing since sliced bread when the market's going up."

Tuesday's stock market declinenotwithstanding, the market rally that began in October has only helped fuel the ETF trade. The 1,415 U.S.-based funds now boast $1.18 trillion in assets, up more than 11 percent just since January, according to XTF Rating Service.

Most recently, Pimco announced that it is coming out with an ETF in March that tracks its Total Return Fund, the largest bond fund in the world.

There are plenty of factors that make ETFs attractive.

They are composed much like mutual funds but trade like stocks. For the most part, they track indexes like the Standard & Poor's 500 or the Nasdaq , as well as numerous sectors, industries and commodities, with gold a particularly attractive ETF class.

They also can be considerably cheaper and more advantageous from a tax perspective.

"There are so many mutual fund companies out there that are definitely higher-cost than ETFs," Casserly says. "If you're going to invest your money in a strategic manner — meaning you're going to ride the market up and down — money managers aren't adding any value and ETFs are definitely the most effective way from a cost-effectiveness perspective."

To be sure, mutual funds have their advantages, and they're certainly not going anywhere.

Mutual funds boast more than $16 trillion in assets, and active managers help provide expertise and flexibility to investors that they can't always get through indexes.

But active managers have been having a miserable time of it lately, with just one in four beating their benchmarks during the market's relatively flat year in 2011. That has only fueled investor interest in ETFs.

"In the ETF world you can be in any sector at any point. You can now invest more like institutions," says Nadav Baum, executive vice president at BPU Investment Management in Pittsburgh, Pa. "Prior to this big explosion, retail investors couldn't invest that way."

There are knocks against them, though.

Because they are fairly static instruments tied to indexes, the diversification they seek to provide also can prove a drag if a large company or two in the underlying components is performing badly.

Perhaps even more so, the industry has seen an explosion of double- and triple-leveraged funds that use derivatives and are designed to hedge against risk, but which also can exacerbate the chances for trouble. Some even blame ETFs for the May 6, 2010 "flash crash" when the Dow industrials lost nearly a thousand points in a few minutes.

Charles Schwab's 2012 ETF Outlook

This year will bring more choices via new uses for ETFs, say Beth Flynn and Michael Iachini, Charles Schwab.

"We think ETFs can play a very important role in portfolios. They're a very cost-effective way of getting broad exposure to segments of the market," says Beth Larson, principal at Evermay Wealth Management in Washington, D.C. "What we don't subscribe to is using ETFs that are targeting what we might refer to as fictitious indexes that are designed just to develop an ETF."

Marc Coffelt, who runs a mid-cap mutual fund as president of Empiric Advisors, believes there always will be a place for his work despite soaring ETF popularity.

"The advantage of active management is you have someone really doing the selection," says Coffelt, whose fund is the Empiric Core Equity Fund , rated two stars by Morningstar. "To know what sector to go into and to choose that sector just based on price momentum over some period — ultimately that is going to prove to be pretty dangerous."

But for whatever weaknesses they may have, ETFs are likely to continue to be a popular investing tool and a key to determining market direction.

"Some of the commentary surrounding these products has made them sound like the hoof beats which precede the Four Horsemen of the Apocalypse," said Nicholas Colas, chief market strategist at ConvergEx in New York. "But for 2012, you can just as accurately call them the most visible source of capital to help U.S. stocks and other risk assets higher."